Quality investing is a style of investing that has become popular in recent years. This is the approach that a number of top investors including Warren Buffett and Terry Smith (Fundsmith’s portfolio manager) pursue.
But what exactly is quality investing? And how do investors pursue this approach?
What is quality investing?
At its core, quality investing is all about investing in high-quality businesses that have the ability to generate consistent returns over the long term. Essentially, the aim of the strategy is to invest in companies that are able to compound their earnings at a high level over the long run, as this tends to produce strong returns for investors.
This style of investing is not new. Indeed, Benjamin Graham, who is widely regarded as the ‘father of value investing’, made the distinction between ‘quality’ stocks and ‘low-quality’ shares nearly 100 years ago. However, the approach has gained more attention over the last decade. This is due to the fact that value investing strategies have underperformed and growth investing strategies have been volatile at times.
How it works
Quality investors tend to focus on three main areas when looking for companies to invest in. These are:
- Profitability – High-quality companies typically have a high return on capital (ROCE), meaning that they’re good at generating profits. Often, this high level of profitability is a result of a competitive advantage such as a strong brand or monopolistic industry position.
- Financial strength – Companies that have strong balance sheets and attractive cash flows are seen as higher quality as they’re generally less vulnerable during economic downturns.
- Stability – High-quality companies demonstrate a track record of stable business performance and growth. Therefore, those pursuing this approach often avoid more cyclical areas of the market such as mining and industrials, and instead focus on areas such as healthcare, technology, and consumer staples.
It’s worth noting that while most quality investors do pay attention to valuation, low valuations are not as paramount as they are for value investors. Often, quality investors are prepared to pay a higher price for a top business. As Warren Buffett says: “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
Examples
As for some examples of stocks that could be suitable for a quality investing strategy, here are three:
- iPhone maker Apple
- Tech giant Microsoft
- UK software company Sage
All of these companies are very profitable, financially strong, and have fantastic long-term track records when it comes to generating shareholder wealth.
It’s worth noting that Apple is Buffett’s largest holding while Microsoft is Smith’s.
A good long-term approach?
The combination of high profitability, financial strength, and consistent, sustainable growth can generate strong returns for investors over the long run.
However, quality investing is not always going to deliver the best results. For example, when cyclical stocks like banks and miners are outperforming, this approach can underperform.
However, history suggests that over the long term, a focus on quality is likely to work pretty well. Just look at Buffett’s track record. Over the last half century, he has averaged returns of around 20% per year using this approach to investing.
